Friday, July 09, 2010

For a friendly EMI

(This article was published in the Open page of The Hindu dated November 22, 2009 and is available at the link:

One of the reasons why ordinary people who survive on salaries have ended up borrowing so much from banks and financial institutions is the simplicity of the repayment mechanism that goes by the name “EMI”, i.e., Equated Monthly Instalment.

The EMI is a fixed payment amount made by a borrower to a lender at a specified date each month. It is used to repay both the interest and the principal each month so that over a given time period, the loan is fully repaid. In practice, the early instalments repay more of the interest component with the later instalments taking care of the principal amount. The advantage with the EMI is that the borrower knows exactly how much is to be paid towards the loan each month and this makes the personal budget easier to manage. When you get your monthly pay-cheque, you also pay out the EMIs on all the loans you would typically have taken, from the now mandatory home and vehicle loans to the sundry personal loans.

However, as much as the EMI has simplified the business of borrowing and repaying, it also wields an unwelcome and unyielding hold over your finances. The cheques have to be paid on the dot, month after month, no matter what contingencies stare you in the face. If the cheques bounce, you pay more by way of charges and penalties. Salary earners get paid roughly the same amount each month. But, anyone who runs a household would know that expenses are just not the same over the months. It could be the start of a school year when so much extra fee is to be paid out, or a festival like Deepavali when money goes up in smoke, as it were. In the West, this could be the extravagance of the Christmas shopping season or the annual vacation.


Here, then, is a suggestion. Instead of insisting that EMIs be paid religiously every month, the banks can offer a “flexi-EMI” plan, where the borrower is allowed the right to default in one month of his choice every year. In return, the EMI amount will be proportionately increased so that the remaining 11 months will together amount to the annual repayment obligation. For instance, if your current EMI is Rs.1,100 a month, under the revised plan you will be required to pay Rs.1,200 a month for 11 months. The annual repayment in either case amounts to Rs.13,200, but the borrower will now be free not to pay anything during the one month — when you expect your finances to be under strain.

This is the basic plan, and from this starting point, variants can be devised. Thus, if for any reason someone wants a two-month default or “vacuum” option, it can also be worked out. Another version would be to offer the product in two options, one allowing a fixed month vacuum where the month in which the EMI is skipped is pre-defined and the other being a variable month vacuum option, where the borrower is free to choose when to skip repayment. Obviously, the second option will be priced a little higher because a beginning-of-the-period default has a higher interest burden.

Simplicity has a lot to do with why the EMI has become so popular. In that sense, the advantage with the changes I have suggested here is that even as the simplicity is retained, the customer is offered an additional convenience at no extra cost.